Bad Financial Advice

Last week I was talking with a coworker about buying a condo and, as is his want, he brought up his own situation. He said he refinanced some years back, took a 15 year mortgage, and will have it paid off in 5 years. Good for him. He then proceeds to say that he will have to take out another mortgage on the house so that he can keep his tax deduction.

I was frozen for a moment. No way. That just doesn’t add up. Mortgage interest is a deduction from your taxable income. So it can reduce you taxable income. But you only get a percentage off. I explained this to him. He countered with the deduction puts him in a lower tax bracket. Again no! It’s a different percentage but you still give the bank more in interest than you get in tax deductions. It’s just simple math.

I mentioned it to another coworker at lunch yesterday and he asked me if I had punched him. “Not physically.” I responded. Then today I’m at lunch with the same coworker and CNN is on the TV with some financial experts taking viewer questions. One viewer said she had enough money to buy a house cash and wondered if she should do it. One of the “expert” financial advisers said that they shouldn’t discount the mortgage income tax deduction.



Fucking hell, man! Is it no wonder the U.S. population is so hosed economically? Our “experts” don’t get math.* So let do it ourselves.

First, let’s understand the way a mortgage works. It is compound interest. This web site gives a good explanation. Notice that the amount of interest you pay is high at the beginning and low at the end. By the time your mortgage comes to an end your tax deduction is fairly small to begin with. If the logic held that your better off with the deduction you’d be refinancing continuously. But let’s get to the math using the first year’s mortgage where you get the most deduction.

On a $200,000 loan at 6% let’s assume you are paying $1200.00 a month. After 12 months you’ve paid out $14,400 and have paid the bank $11,933 in interest. Now let’s assume your income is $75,000 per year. That puts you in the 25% marginal tax rate. Now remember, tax rates don’t apply to your whole income. Just the portions that go over the thresholds. See here.

So assuming no other deductions, with the mortgage your net income is
75,000 – 14,400 – (4386.25 + ((75,000-11933) – 31850.00) * 0.25) = 48409.50

Now, if you don’t have the second mortgage you don’t get the tax deduction, but you also don’t have mortgage payment.
75,000 - (75,000 * 0.25) = 56,520.00

For our financially challenged “experts” 56,520.00 is greater than 48409.50.


* Now on the cash purchase it is possible that the opportunity cost of buying the house cash versus investing the money could make financing the house more advantageous, but that wasn’t the “expert’s” advice. And someone will have to show me the spread sheet on that one.

Just to check the concept of investing the mortgage principle I put together a spreadsheet for a $150K mortgage at 5.62% interest (from the Trib web site). With $863 monthly payments a person would pay 160,690 in interest over the course of 30 years. If the $150K was put into CDs for the full time at 3.6% (what my broker could get me today for a long term Cd), the person would earn 292,311 in interest. A net gain of about $132,000. If on the other hand you were to invest $863 a month at 3.3% interest (what my broker can get for short term interest CDs) for 30 years you would earn 221,832 in interest and not pay any interest out.